IRR Calculation

Internal Rate of Return

Summary of IRR. Calculation

The Internal Rate of Return (IRR)
is the discount rate that results in a net present value of zero for a
series of future cash flows. It is an Discounted Cash Flow (DCF) approach to
valuation and investing just as Net Present
Value (NPV). Both IRR and NPV are widely used to decide which
investments to undertake and which investments not to make.

Calculation of IRR: The major difference is that while
Net Present Value is expressed in monetary units (Euro's
or Dollars for example), the IRR is the true interest yield
expected from an investment expressed as a percentage.

Internal Rate of Return is the flip
side of Net Present Value and is based on the same principles and the same
math. NPV shows the value of a stream of future cash flows discounted back
to the present by some percentage that represents the minimum desired rate
of return, often your company's cost of capital. IRR, on the other hand,
computes a break-even rate of return. It shows the discount rate below
which an investment results in a positive NPV (and should be made) and
above which an investment results in a negative NPV (and should be
avoided). It's the break-even discount rate, the rate at which the value
of cash outflows equals the value of cash inflows.

Many people find the percentages of IRR
easier to understand than Net Present Value. Another benefit from IRR is
that it can be calculated without having to estimate the (absolute) cost
of capital.

When IRR is used, the usual approach is
to select the projects whose IRR exceeds the cost of capital (often called
hurdle rate when used in the IRR context). This may seem simple and
straightforward at first sight. However a major disadvantage of using the
Internal Rate of Return instead of Net Present Value is that if managers
focus on maximizing IRR and not NPV, there is a significant risk in
companies where the return on investment is greater than the Weighted
Average Cost of Capital (WACC) that
managers will not invest in projects expected to earn greater than the
WACC, but less than the return on existing assets. IRR is a true
indication of a project's annual return of investment only when
the project generates no interim cash flows - or when those
interim investments can be invested at the actual IRR.

The aim of
the value-oriented manager should be to invest in any project that has a
positive NPV! If IRR usage is unavoidable, then
managers are advised to use so called Modified IRR (which, while
not perfect, at least allows to set more realistic interim reinvestment
rates) and additionally to keep a close look on interim cash-flows,
especially if they are biased to the beginning of the project period
(the distortion is bigger then).

In other words: the aim should not be
to maximize the Internal Rate of Return, but to maximize Net Present
Value.